Indiana Law Journal Volume 92 Issue 4 Article 6 Fall 2017 Taking Systemic Risk Seriously in Financial Regulation Todd Henderson University of Chicago, [email protected] James C. Spindler University of Texas Law School, [email protected] Follow this and additional works at: https://www.repository.law.indiana.edu/ilj Part of the Administrative Law Commons, and the Banking and Finance Law Commons Recommended Citation Henderson, Todd and Spindler, James C. (2017) "Taking Systemic Risk Seriously in Financial Regulation," Indiana Law Journal: Vol. 92 : Iss. 4 , Article 6. Available at: https://www.repository.law.indiana.edu/ilj/vol92/iss4/6 This Article is brought to you for free and open access by the Law School Journals at Digital Repository @ Maurer Law. It has been accepted for inclusion in Indiana Law Journal by an authorized editor of Digital Repository @ Maurer Law. For more information, please contact [email protected]. Taking Systemic Risk Seriously in Financial Regulation M. TODD HENDERSON & JAMES C. SPINDLER Bank regulationfailed in the run up to the financial crisis of2008, as it has numerous times in the course of U.S. history. This is despite the existence oftraditionalpruden- tial regulation, such as capital adequacy mandates, reserve requirements, and bank examination, as well as more common legal remedies, such as tort and contract litigation. Unsurprisingly, in the wake of these failures, many reforms have been proposed, and some adopted, to try to reduce bank risk taking. These reforms include limiting bank size, requiringbank managers to be paiddifferently, restrictinginvest- ment in high-riskfinancialproducts, and, ofcourse, tightening up existingprudential regulation. In this Article, we first categorize these proposals into traditionalcategories of regulation-ex ante and ex post forms-and point out the weaknesses of each. Ex post regulation-generally,liability after the factfor harm caused-fails almost by construction: given externalities of systemic risk and leverage, judgment-proofness is virtually guaranteedand is uninsurable. Ex ante regulation-whichcomprises the bulk ofcurrentprudential relation-is, as a startingpoint, inefficient because itfails to take into account both private information and subsequent public information. More vexingly, ex ante regulation encourages worse behavior: size limits and transactions taxes encourage higher-octane bets, and asset restrictions lead to the recreation of the same risk profiles in less efficient ways. We then describe an intermediateform, what we call the "regulatoryveto, " which allows regulators to intervene to reduce bank risk taking after banks have started their activities, but before the losses have occurred We show how the regulatory veto is, potentially, an elegant solution to the information problem presented by ex ante regulation and the judgment-proofness problem of ex post regulation of bank activities. However, the regulatory veto is subject to a structuralflaw: banks get to move first in aform of the ultimatum game and choose supra-optimallevels of bank activities, which are not quite bad enough to cause regulators to shut them down. To mitigate this flaw, we propose reforms to enhance regulators'ability to credibly commit and to reduce banks' ability to game the system. INTRODUCTION ........................................... ....... 1560 I. THE BANKING SYSTEM: A PRIMER.. ......................... ......... 1567 A. BANKING BASICS-LONG-SHORT MISMATCH, RUNS, AND MAINTAINING CONFIDENCE ................................... ................ 1567 B. BANKING REGULATION BASICS..................... ................ 1571 1. PRUDENTIAL REGULATION ............. ..................... 1573 2. CAPITAL AND RESERVE REGULATION ......................... 1576 3. THE REGULATORY VETO .................................... 1578 C. REGULATORY REFORM PROPOSALS ............................... 1582 * Todd Henderson is Professor of Law and Aaron Director Teaching Scholar, The University of Chicago Law School; James Spindler is The Sylvan Lang Professor, University of Texas Law School and Professor, University of Texas McCombs School of Business, respectively. 1559 1560 INDIANA LAW JOURNAL [Vol. 92:1559 II. A SIMPLE MODEL OF REGULATION OF BANK RISK TAKING ............................ 1584 A. THE MODEL ............................................... ..... 1585 1. THE BANKING FIRM AND ITS PROJECTS .......... ............. 1586 2. SHAREHOLDERS ........................................... 1587 3. BANK CREDITORS ................................................ 1587 4. THE REGULATOR AND SYSTEMIC RISK.......... ............... 1588 B. How DO THE VARIOUS ALTERNATIVES FARE? .. ... .. .. ...... ............. 1589 1. A BASELINE: LAISSEZ-FAIRE .......................... 1590 2. Ex POST: LITIGATION AND INSURANCE ......... .............. 1591 3. Ex ANTE REGULATION: SIZE AND ASSET TYPE RESTRICTIONS.....1594 4. A MIDDLE GROUND: THE REGULATORY VETO ................. 1604 III. How TO MAKE BANKING REGULATION BETTER ........................ 1609 CONCLUSION ..................................................... ...... 1611 INTRODUCTION Modem American bank regulation is an array of devices designed to limit risk at individual banks and in the banking system as a whole. Allowing banks to take deposits and other short-term liabilities in order to invest in loans and other long- term financial assets creates wealth, but private wealth-generating activities may not be socially valuable if the costs they externalize onto others exceed the benefits. Banking regulation, therefore, attempts to attain the socially optimal level of banking activity by limiting the activity of banks.' Departures from the optimum hurt society: too little lending lowers bank profits and reduces the economy's access to credit, while too much lending and investment creates excessive risks that will largely, in the event of catastrophic failure, be borne by someone else. The regulatory tool kit of bank regulation is diverse and includes both what we term ex ante and ex post forms of regulation. Consider first ex ante bank regulation (often referred to as "prudential" bank regulation).2 Entry into the banking business is regulated by state and federal agencies. The kinds of activities banks can engage in-the "business of banking" and activities "necessary" to this business-are lim- ited.3 "Safety and soundness" rules 4 limit the types and sizes of loans, restrict lending and other dealings to and with bank executives, mandate amounts of cash that must be held in reserve,5 and prescribe limits on the amount of leverage that banks may 1. For welfarists, this is the purpose of regulation of any activity. As discussed below, the case for active and aggressive regulation is stronger in the banking context than in other areas. While it might make sense to let our regulation of most consumer goods be handled through voluntary market transactions and an ex post remedy for fraud or other harm, this approach is unlikely to work for banking. 2. See About the OCC, OFFICE OF THE COMPTROLLER OF THE CURRENCY, https://www .occ.treas.gov/about/what-we-do/mission/index-about.html [https://perma.cc/SGE2-H77X]. 3. E.g., The National Bank Act, 12 U.S.C. § 24(7) (2012). 4. See, e.g, OFFICE OF THE COMPTROLLER OF THE CURRENCY, U.S. DEP'T OF TREASURY, BANK SUPERVISION PROCESS: COMPTROLLER'S HANDBOOK (2007) (describing the seven categories of safety and soundness regulation). 5. Various state and federal regulators, such as the Department of Treasury or the Office of the Comptroller of the Currency, prescribe reserve requirements-cash on hand banks must 2017]1 TAKING SYSTEMIC RISK SERIOUSLY 1561 take.6 Disclosure obligations under Basel Pillar 3 mandate disclosure to enable "mar- ket discipline" of banks.7 Federal deposit insurance mandates that banks pay premi- ums to insure demand deposits against deficiencies.8 Finally, various government agencies have broad statutory power to seek injunctive relief and damages in the event of losses caused by banking.9 So far, banking regulation looks a lot like other areas of regulation, albeit far stricter and more comprehensive. Ex post measures generally involve mopping up after the damage has been done. Jilted creditors and counterparties may pursue their remedies in court, as may the government, particularly in the case of a federal payout. Banks that fail are forced into receivership, their assets unwound, and creditors paid off to the extent possible. o Finally, bank personnel who have committed wrongdoing may be sued or prosecuted. In addition, there is a rather unique banking regulatory institution that spans ex post and ex ante measures. Specialized regulators, known as "examiners," are as- signed to individual banks." Examiners have an additional, and unusual, mandate: maintain to repay depositors and creditors. For example, the Federal Reserve Board's Regulation D prescribes reserve requirements beyond those required by law. Reserve Require- ments, FEDERALRESERVE.GOv, http://www.federalreserve.gov/monetarypolicy/reservereq.htm [https://perma.cc/4JJ8-XTK6] (last updated Oct. 27, 2016). For example, the Garn-St. Germain Act exempts the first $2 million from reserve obligations, and the first $25 million above this is subject to a relatively low (i.e. 3 percent) reserve requirement by the Monetary Control Act of 1980. Id. Regulation D sets the reserve requirement above $115.1 million at 10 percent. Id. 6. Specifically, capital adequacy requirements, primarily under the Basel Accords, limit the